The Growing Federalization of the Duty to Monitor (Part 1)

The Delaware courts were slow to come to the realization that directors ought to have a duty to monitor.  The doctrine was only developed in Caremark, a case decided in 1996.  The Delaware courts came to the area late.  As the court in Caremark noted, obligations to monitor were already arising from other areas, such as the sentencing guidelines. 

The decision was at some level a legal oddity.  The lower court effectively overturned the higher court, reversing Graham v. Allis-Chalmers, the Supreme Court decision from three decades earlier that had effectively held there was no such duty.  Of course, it still took another decade before the Supreme Court actually affirmed the reasoning in Stone v. Ritter, 911 A.2d 362 (Del. 2006).  See also In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106 (describing Caremark as a "reassessment" of Graham). 

The "classic" Caremark claim involved allegations of "directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation . . ."  In other words, the claim sought to impose liability for matters unknown to the board.  In those circumstances, liability could arise where the board should have known about the harmful activity.

The court went on to define the circumstances where ignorance could nonetheless result in liability.  Plaintiffs had to show "a sustained or systematic failure of the board to exercise oversight--such as an utter failure to attempt to assure a reasonable information and reporting system exists".  According to the Court in Stone v. Ritter, this occurred when directors "utterly failed to implement any reporting or information system or controls" or where they implemented a system but "consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention."

In effect, this standard gave directors a pass on liability whenever they had a reporting system in place.  What the courts did not do and have not done is define the minimum content of an adequate reporting system.  It was simply enough to have one in place, irrespective of the type or quality of information provided to the board. 

Thus, in Amylin, for example, the Chancery Court, in a decision upheld by the Supreme Court, found that directors did not have to have a reporting system that made them aware of contractual provisions that "materially reduce[d] the shareholder franchise."  Rather than require a reporting system robust enough to provide that type of information to the board, the court merely encouraged outside counsel to "be especially mindful of the board’s continuing duties to the stockholders to protect their interests."

Having a reporting system is not enough.  To the extent that the system has little specific content, disclosure to the board becomes a matter of discretion.  Officers and other employees can find justifications to withhold important information  from the board.  Officers have a particular incentive to do so where the information will make them look bad (the board can, after all, dismiss any officer, including the CEO).  The incentive to keep boards uninformed is discussed at greater length here:  Essay: Neutralizing the Board of Directors and the Impact on Diversity. 

For the foreseeable future, Delaware courts are unlikely to provide content to the reporting system in place at the board level.  Standards will, however, develop.  It will be the federal government that fills the vacuum, something that has already begun to occur as we will discuss in the next post.